Side Deals in a Gray Area

Correspondence among investors known as “big-boy letters” is about to face its first significant legal challenge.

JENNY ANDERSON

Global deal making is on a tear, accompanied by a surge of insider trading cases.

While regulators have focused on the buying of options or stocks on leaks about deals before they become public, there is another, more subtle way that big investors can trade while possessing information that the market does not have.

And it is — for now at least — all perfectly legal.

This little-known leeway comes in the form of “big-boy letters” — letters between buyers and sellers that say, in essence, “We are all big boys here, so let’s not sue each other.”

Big-boy letters are typically used when an investor has confidential information about a stock or bond and wants to sell those securities. By signing the letter, the buyer effectively recognizes that the seller has better information but promises not to sue the seller, much like a homebuyer who agrees to buy a house in “as is” condition.

But what happens when that security is then sold in the market and plummets in value? Put another way, what if that house collapses soon after it is sold to another buyer?

The use of big-boy letters is about to face its first significant legal challenge. In a lawsuit set to go to trial next month, a Texas hedge fund contends that it was on the losing end of such a letter in 2001, when Salomon Smith Barney, now Smith Barney, sold more than $20 million worth of World Access bonds to the Jefferies Group, the investment bank, using a big-boy letter.

Jefferies, in turn, flipped those bonds to the hedge fund, R2 of Fort Worth, through the Fimat Group, a service that matches trades. When World Access, a telecommunications company, announced that it was out of cash two days later, the bonds plummeted 30 percent, leaving the hedge fund holding the bag.

In a world of rapid trading, complex and arcane derivatives and secretive traders, the contours of what makes a level playing field for investors are sometimes hard to see.

Big-boy letters are a case in point. They are widely used and represent a private contract between presumably sophisticated investors.

Lawyers agree that big-boy letters do not technically shield either party from insider trading laws, but rather protect the two parties from suing each other. Still, the letters are widely used and have not — until now — been legally challenged. (The Securities and Exchange Commission has not weighed in on the letters.)

And lawyers do not agree on what happens when the securities at issue in big-boy letters are then put into the market with trades that might otherwise be deemed illegal.

Typically, insiders are barred from trading on significant information they have agreed to receive in confidence that gives them an advantage over other investors.

“With big-boy letters, we have a situation where the public at large can be exposed to tainted claims without knowing about it,” said Edward S. Weisfelner, the chairman of the bankruptcy and corporate restructuring practice group at the law firm of Brown Rudnick.

Big-boy letters are used in other situations. For example, companies might use them to sell stock when they are close to reporting earnings and clearly have an information advantage. Big-boy letters “avoid having to deal with the obvious, that someone knows more,” said Dennis J. Block, a senior partner at Cadwalader, Wickersham & Taft.

In another case involving big-boy letters, Barclays, the British bank, disclosed recently that the Securities and Exchange Commission was considering a civil enforcement action against it. According to government filings and a related lawsuit brought by Michael Econn, a former credit analyst at the bank, Barclays’ employees traded debt while simultaneously sitting on bankruptcy committees, giving them nonpublic information that would inform those traders about the value of the debt.

According to Mr. Econn’s lawsuit, Barclays supervisors told the employees the trades were acceptable because the bank was using big-boy letters, even though only a few big-boy letters were ever drafted.

Barclays says it does not comment on regulatory matters. Mr. Econn’s lawyer declined to comment.

In the lawsuit brought by the R2 hedge fund, which is scheduled go before a federal jury in Manhattan, the issue is whether Smith Barney and Jefferies worked together to unload toxic securities into the market and whether Jefferies was obligated to disclose the existence of the big-boy letters to the fund.

E-mail messages that have emerged in documents filed in a related suit in Texas indicate that traders were frantic to sell the World Access bonds before the company’s dire financial condition became known. The same day that Smith Barney received detailed confidential information about World Access, it asked Jefferies to find a buyer for its bonds, according to R2’s lawsuit. Buyers were scarce.

The following afternoon, as the market was nearing its close, a Jefferies trader sent an e-mail message to Fimat Group, which was helping Jefferies’ find a buyer: “I need an answer this thing is a mess.”

By the end of the day, the bonds were sold to R2 with Jefferies selling to Fimat minutes before buying from Smith Barney to cover the trade. Jefferies and Smith Barney completed their big-boy letter the next day.

“We believe it is clearly illegal for someone with material nonpublic information to dump securities on unsuspecting buyers in the marketplace by funneling the trade through a middleman who signs a big-boy letter,” said Andrew Cole, a spokesman for R2. “If we are proven wrong, then a giant loophole exists that essentially makes the insider trading laws meaningless."

A spokesman for Citigroup, which owns Smith Barney, said, “We believe the case is without merit and will fight it vigorously.” A Jefferies spokesman declined to comment.

Documents filed in the related Texas case suggest that Smith Barney may argue that it did not agree to protect the confidentiality of the information it received, making it free to trade. Jefferies may contend that it was unaware that Smith Barney had confidential information.

The genesis of the case was the popping of the bubble in telecommunications spending. In 2000, World Access, a Nasdaq-listed company, provided bundled telecom services, including voice, data and Internet to small and medium-size businesses in Europe.

At the end of that year, World Access was required by its lenders to buy back more than $160 million worth of bonds under terms of a previous covenant. In January 2001 it began the buyback. By February 2001, the stock of World Access hovered around $3 and its bonds, which were highly illiquid, were trading at about 64 cents on the dollar. It was a troubled company in a flailing industry.

On Feb. 8, World Access executives called investors at J.& W. Seligman & Company, another major bondholder, and said they needed approval to restructure the tender offer to buy back only $80 million worth of bonds. The company was running out of money and if the bondholders did not agree to the changes, it faced possible bankruptcy.

The next day, a Seligman executive called other bondholders. He made clear that the information was confidential, according to R2’s lawsuit, and over the next few days, sent the group detailed financial information, including a PowerPoint presentation with projections, all marked confidential. Three days later, the bondholders met with the company at Seligman’s office on Park Avenue in Manhattan to discuss the materials and the company’s prospects.

Soon after that meeting, a trader from Smith Barney called Jefferies, looking for bids on World Access bonds. The Jefferies trader, by e-mail, informed Smith Barney that there had been a buyer, but that the buyer had apparently got wind of the bondholder deal — information that had not been publicly disclosed — and had backed away.

By Feb. 13, the Smith Barney trader appeared agitated, anxious to unwind his position, according to the e-mail messages. As Jefferies tried to pry out more information about the deal, the trader said he was not authorized to say anything because the bank was restricted, meaning that it had nonpublic information.

As the afternoon wore on, the e-mail became more testy. At 3:30 p.m., seeking a buyer, the Jefferies trader e-mailed Fimat: “I need to execute 20mm — forget the rest — this is a prob if nothing gets done.” At 4:05, Jefferies sold $20 million of bonds to Fimat for $498.75 per $1,000 bond. Four minutes later, it covered the sale by buying $20 million of bonds at $487.50 for every $1,000. By the end of the day, R2 bought the bonds for $501.875. When the World Access news release came out, disclosing its true financial condition, the bonds dropped to $360 per $1,000.

In general, lawyers disagree as to whether the buyer of the securities, knowing that the securities were obtained via a big-boy letter, has an obligation to inform the next buyer.

Howard Seife, head of the bankruptcy practice at Chadbourne & Parke, said: “If I am the buyer and I want to resell, it would be prudent for the new seller to enter into a big-boy letter. You are protecting yourself to the new buyer in the chain.”

Others disagree. “The existence of a big-boy letter is not a material fact that needs to be disclosed in connection with a sale,” said Mr. Block from Cadwalader, Wickersham & Taft.

Interviews with more than a dozen law firms elicit a wide range of opinions on big-boy letters. “It’s a fairly gray area,” Mr. Seife acknowledged.

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